Introduction
Discovery Silver (OTCQX:DSVSF) has been advancing a massive silver project in Mexico for several years. Development projects always are high risk because so many things can go wrong before reaching first pour. And then, once they reach first pour, they still need to hit their production and cost targets, along with a much higher silver price.
Long-term development plays are not my favorite place to find good risk-reward opportunities, but they can be lucrative if you get lucky. Ideally, I prefer development projects that are within two years of construction to reduce my risk. I think Discovery is very close to that window. They will release a feasibility study in early 2024 and attempt to also complete permitting in 2024. It’s possible they could begin construction in 2024, although I expect it to slip to 2025.
If they do begin construction in 2025 and silver prices are over $50, their share prices should explode from current levels. Those are the types of opportunities that get my attention, regardless if it’s a high-risk development project.
Comment from the company via email to me: As far as development projects go, Cordero is relatively low risk … there is existing infrastructure, the local topography is gentle, the deposit comes to surface (no pre-stripping), no acid generating rock, the process design is as simply as it gets, no waterways to deal with, no glacial tills/clays to deal with, etc.
They will have to overcome three hurdles. The first will be open-pit permitting, which is currently under scrutiny in Mexico. Some investors would say this risk alone is too high, but I’m confident that it will be permitted, or I wouldn’t be writing this article. I have spoken to the IR rep and the CEO of Minera Alamos, who also is currently permitting an open-pit project in Mexico. Both are confident their permits will go through.
The second hurdle will be financing. We can never know how a project will be financed and how much it will hurt shareholders. The capex is high ($450 million) and will require a lot of share dilution. My worry is if the loan requires onerous covenants, such as hedging, or if they do a streaming deal that reduces their FCF.
The third hurdle is avoiding getting taken out by a larger company. Thankfully, Eric Sprott owns 25% of the company and knows the potential value of this project. I think this hurdle will be easily crossed.
I always like to point out that investing in PM miners is speculating. We’re gambling since so many things can go wrong. My success rate on PM development stocks has been around 20%, which is not great, although the main reason for the low success rate is that most of them get acquired for low premiums (and there go the big returns). We’re also betting that silver prices will go much higher, which is an assumption.
|
Stock Name |
Symbol (US) |
Type |
Category |
Share Price (US) |
FD Shares |
FD Mkt Cap (6/24/2023) |
|
Discovery Silver |
OTCQX:DSVSF |
Silver |
Late Stage Development |
$0.64 |
421M |
$264M |
Company Overview
(Refer to the company’s website for data mentioned in this article.)
Discovery Silver is advancing a large silver project (Cordero) in Mexico. Cordero has about 1.5 billion oz. of AGEQ (60 gpt), with significant offsets of lead, zinc, and gold. They’re focusing on higher grades to improve the economics (about 500 million oz. at 90 gpt AGEQ). I’m valuing the company using only 500 million oz’s of resources, but the other 1 billion oz’s of resources could be used to expand production in the future.
They released a PFS in 2023. The capex increased to $450M. They plan to mine 33 million oz. (AGEQ) annually at around 90 gpt (AGEQ), with an AISC of around $13 (this will increase by the time they get to production). This is their starting pit, and production will likely increase.
The economics are surprisingly good for their low grade (this is because the project benefits from a low strip ratio, excellent metallurgy, and efficiencies from high throughput levels). The after-tax IRR is 28% at $22 silver. As long as silver prices are above $25, I think it can get financed. The payback is less than two years. Because of the high production, Cordero has huge leverage as silver prices rise. If silver is over $30, the payback period is only one year.
They have been finding higher grades and new discoveries on Cordero’s large property (85,000 acres). They drilled 50,000 meters in 2021. Recent drill results have been excellent.
Feasibility study work will be ongoing through 2023, completing in early 2024. They also will be permitting in 2023-2024. We could have a construction decision as early as next year. Perhaps the first pour in 2026, but my guess is 2027.
The management team has an excellent track record. The CEO, Tony Makuch, was the guy who made Kirkland Lake a success. He also had success at Lakeshore Gold. Tony Esplin, the COO, spent more than 20 years at Newmont, successfully running some of the biggest gold mines in the world. They’re ready to build this mine (refer to this recent podcast where the CEO provides an update). They have 35% insiders, with management and founders owning 10% of the shares and Eric Sprott with 25%. I don’t think they will sell early and want to take this to production.
If we assume silver reaches $75, they could expand production to mine 1+ billion oz. Annual production could be massive. Let’s assume they reach 35 million oz. of AGEQ annual production. That would generate free cash flow of around $1.5 billion per year. Using a 10x multiplier, that values the company at $15 billion. So, you can see how much leverage they have to higher silver prices.
Company Info
Cash: $64 million.
Debt: None.
Current Silver Resources: 500 million oz (80 gpt) AGEQ.
Estimated Future Silver Resources: 500 million oz (80 gpt) AGEQ.
Estimated Future Silver Production: 30 million oz AGEQ.
Estimated Future Silver All-in Costs (breakeven): $25 per oz AGEQ.
Scorecard (1 to 10)
Properties/Projects: 8.
Costs/Grade/Economics: 7.
People/Management: 8.
Cash/Debt: 7.
Location Risk: 6.5. Comment from the company via email: I think this score should be higher. We are in a region where they have been mining silver for more than 400 years. There are large operating mines/companies in the region. Our nearest local community is the town of Parral which has its own mining university. Despite the political rhetoric Mexico is still permitting mines. Agnico, a risk-averse company that only invests in top tier jurisdictions, recently invested US$580M in San Nicolas …. this in my mind provides strong confidence this will still be the case moving forward.
Risk-Reward: 7.5.
Upside Potential: 9.
Production Growth Potential/Exploration: 8.
Overall Rating: 7.5.
Scorecard Explained
The scorecard is my opinion of these various factors on a scale of 1 to 10, with 10 being the best. Ideally, we want to see a value of 7.5 or higher for each item. A 6.5 or lower can be considered a red flag.
Strengths/Positives
Significant upside potential.
High FCF potential.
Quality property.
Strong management.
Production growth potential.
Large resources.
Risks/Red Flags
Potential permit issues.
Unknown capex financing.
Dependence on higher silver prices.
Location risk in Mexico.
Speculation stock (high risk).
Low Trading Volume / Low Liquidity on OTC (Note: I would purchase this on the Canadian stock exchange for more liquidity).
Estimated Future Valuation ($75 silver)
Silver production estimate for the long term: 30 million AGEQ oz.
Silver All-In Costs (break-even): $25 AGEQ per oz. (Comment from the company: So, to clarify, you are assuming an approximate ~90% increase in our AISC due to general cost inflation over the next few years?).
30M oz. x ($75 – $25) = $1.5 billion annual FCF (free cash flow).
$1.5 billion x 5 (FCF multiplier) = $7.5 billion.
Current FD market cap: $264 million.
Upside potential: 2700%.
Future Valuation Explained
This is an estimated return, and will only occur if all assumptions are correct. A more likely outcome will be something less than this amount, although it is not crazy talk to expect silver to exceed $75.
My All-In Costs are the expected costs that will generate FCF (free cash flow).
I used a future FCF multiplier of 4, which is very conservative, to allow for share dilution to finance the capex. Note that a quality producer today can easily have a multiple of 15.
I used a future PM price of $75 silver because I’m a long-term investor who plans to wait for higher silver prices. I expect to see this level reached within 3-5 years. In fact, I use $100 silver for valuations on my website since that is my expected future price. I tone it down a bit to $75 on Seeking Alpha, which I think is more reasonable.
It’s my opinion that gold drives the silver price, and that macroeconomics drives the gold price. The only reason I expect to see $100 silver is because I expect to see at least $3,000 gold. That would be a GSR (gold-silver ratio of 30).
A $75 or $100 silver price may seem like pie-in-the-sky fantasy, but silver traded at $49 in 2011 when gold was at $1,935. If gold rises 50% from its current level, there’s a good chance that silver will rise 150%. This is usually what happens as the GSR gets squeezed. Of course, this is an assumption.
Balance Sheet/Share Dilution
They currently have a strong balance sheet, with $64 million in cash and no debt. However, they will be acquiring around $250 million in debt to build the mine. Ideally, they will pay it off within three years.
They have 421M FD shares, which I consider high for a developer. They’re likely to dilute this by another 50% to finance the capex and additional development costs. I expect about 50% dilution and perhaps a bit more. This is one of the reasons their FD market cap is so low.
The capex is $450 million. If they borrow 2/3, that would be around $300 million, and leave $150 million for share dilution. That would be the ideal capex financing. Depending on how much they appreciate in value before they have to do the capex financing, the dilution could be +/- 50% of their market cap. Note that if they explode in value prior to capex financing, it could be as low as 30% dilution.
Risk/Reward
As I mentioned at the beginning, this is a high-risk stock, along with some of the reasons why. I also showed the high upside potential if silver prices rise. You must balance these two to decide if you want to accept that risk.
I’m not risk averse and do not mind holding high-risk stocks such as Discovery Silver, although I keep my cost basis allocation low (generally 1% or less of my total cost basis) so that I won’t get hurt.
I recognize that this is a long-term play and will likely not reach my expected valuation until around 2027 or 2028. I also recognize that many things can prevent my expected valuation from being reached. However, while this is a long-term play with many risks, it also has extremely high upside potential, which is leveraged to the silver price.
The biggest risk is that silver prices won’t rise, or inflation will cause costs to rise significantly, reducing our expected margins. Plus, political risk in Mexico seems to be increasing. Of course, those are not the only risks. This is speculation investing, and many things can go wrong.
A significant risk is permitting. There are no guarantees that they will obtain their required mining permits. Another risk is water, although they have provided guidance that this will not be an issue.
Another significant risk is their costs and breakeven point. In the first 2-3 years of production, they will need to make enough FCF to pay back their debt. We can only assume at this time that their costs will be substantially below the spot price.
I have projected their costs to be well above their PFS AISC. So, as long as silver is above $25, I expect them to be fine. And if silver is above $30, I expect them to have very high FCF.
Investment Thesis
Since this is a development stock, it’s really an optionality play. I’m betting that their large resources will turn into large FCF. Moreover, I’m buying their silver in the ground today for about 50 cents an ounce, which will be worth much more once it comes out of the ground. You could say that I’m buying their silver low and that I plan to sell it high (ideally above $10 per ounce).
What I like about this stock is that it has most of what I look for (other than an ideal location and very close to production) in a development stock. It checks most of the boxes.
- Quality project.
- Long mine life.
- High free cash potential.
- Production growth potential.
- Strong management team.
- Strong path to production.
- Economic.
- Highly undervalued.
When silver gets to $50 or $75, I want to own silver producers that are experiencing massive FCF from these high prices. This will allow companies to clean up their balance sheet and acquire other companies with their large cash inflows. They also will be able to buy back shares and pay out dividends. Plus, with a clean balance sheet, they should receive a high FCF multiple.
A company like Discovery Silver that can’t be acquired (unless it wants to be) can become a shark. They can use their cash to grow via acquisitions. They have the potential to become a very large company. So, while I’m valuing them as a potential 25-bagger, that’s not their limit. Remember, this is a 1.5 billion oz deposit. This mine will likely last more than 20 years. I won’t hold the stock for 20 years, but I might hold it for ten if it’s a monster.
Strategy to Manage Risk
I use a pyramid approach (as discussed in my book) to manage risk, along with low allocations (normally less than 1% per individual stock), whereby I use less risky assets at the base of the pyramid and riskier stocks as I move up the pyramid.
As the shape of a pyramid implies, the bulk of my portfolio is on the lower half. Also, the base of the pyramid should be strong enough to withstand major corrections when the more risky stocks higher up on the pyramid get obliterated (sometimes down 70% or more).
I don’t trade. Instead, I buy and hold. However, I have exit strategies for each stock. I often add to stocks that crash more than 50% if I still like the story, thereby reducing my cost basis. And I always buy big corrections to improve my portfolio (this is usually the best time to buy).
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
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